Allocations of Risk Capital in Financial Institutions

Saita – Financial Management, 1999

Abstract

Why this Paper ? • Attention usually focussed on Risk Measurement • Application of these measures in actual processes are

usually unaddressed. • Risk decision is separated from risk analysis Focus of this paper • Implementation issues involved with using VaR

measures in Capital Allocation process. • Capital Allocation and the role it plays in evaluating

RAP . • Capital Allocation is critical to ensure that the

sophisticated risk measures deliver expected results. • Aggregate risk control requires Integrated Risk Mgmt.

Key Measures of Risk

• Market Risk

• Credit Risk

• Counterparty credit risk

• Liquidity risk

• Operational risk

• Legal risk

• Reputational Risk

VaR

• Depends on time interval and confidence level

• Ex : 99 % annual VaR is $10 mn

• The maximum loss that the bank can face on 99 out of

100 occasions over the next year is $10 mn

• The actual loss is not specified.

• The minimum loss on 1 out of 100 days is $10 mn

• Single position as well as portfolio level VaR is possible.

Distribution of P&L – VaR

Economic Capital

This is more about the solvency or survival of a bank….

Capital at Risk ( CaR )

• CaR is a statistical measure of the resources required to

absorb unexpected losses over a given period (typically

one year) with a 90% level of confidence.

• Capital-at-risk is same as economic capital where the

difference is a much lower confidence. ( say from 99.9 %

to 90 %)

• Used in addition to EC

• Measurement is more relevant to shareholders

2-dim’n of RMS Evolution

Why Capital Allocation is Important

1. Risk to be controlled ex-ante ( risk limits)

2. Capital at Risk (CaR) is the basis of

Performance evaluation ( RAP)

Development of RMS is described along 2-dim’ns

1. Extension ( no of diff. types of risk captured in

a single risk measure ).

2. Depth ( no of diff. types of objectives a risk

measure achieves ).

4 Objectives of Risk Measures

• Measures to ensure firm wide risk is consistent with

risk preferences of shareholders.

• Measures to define risk limits at business segment

level to guarantee ex-ante risk levels are consistent.

• Measures to facilitate performance measurement on

a risk-return basis.

• Measures to ensure that efficient allocation of CaR.

4 Stages of Risk Management

• Risk Measurement ( how much capital is at risk ,

monitoring total risk, verifying capital adequacy )

• Risk Control (Max Risk limit for each unit , preventing

a bank from taking excessive risks)

• RAPM . ( What is the RAROC , measurement of

performance ) RAROC = Profit / CaR

• CaR Allocation.( How much capital should be granted

to each unit next year ? , Efficient use of

shareholder’s capital.

Some points to note….

• Depth plays a critical role in risk.

• The key issue is how to transfer risk measures from a

portfolio of assets and liabilities to a portfolio of

business units.

• Risk management requires both financial and

organizational theory.

• RAPM . ( What is the RAROC , measurement of

performance ) RAROC = Profit / CaR

• CaR Allocation.( How much capital should be granted

to each unit next year ? , Efficient use of

shareholder’s capital.

Interdisciplinary approach of RMS

• Identify the key risks measures

• Who takes what kind of risk and their degree of risk

specialization ?

• Centralization / De-centralization of the capital

allocation process.

• Measures used to evaluate RAP ( Ex : RAROC )

• Linkages b/w RAPM and Reward / Punishment

System.

Identifying Risk taking centres

• Initial step for designing a control system is to define

profit and cost centres.

A. Single Risk vs. Multi-Risk Units: The

Rationale for Risk Specialization.

B. Single Risk vs. Multi-Risk Units: Risk

Specialization and Transfer Pricing

The Case for Specialization

• Higher Returns

The most qualified personnel can handle.

• Effective Auditing

Deviations are easy to track .

Not common to divide organizational units based on

risk alone

Geographical location, customer segments ,

product lines, etc..

Obstacles for Specialization

• Achieving total division of risks may be difficult. (

segregating directional risks and volatility risks)

• Synergies of multiple risks can be overlooked. ( credit

and interest rate risk in a junk bond portfolio )

• Disaggregating returns may not be possible.

Thus a transfer price has to be defined whenever mutli-

risk position is transformed to a single risk position

through an internal deal.

Characteristics of Allocation

• Top-Down method ( CaR and performance objectives

are assigned by senior managers ). This is very

common in highly centralized organizations.

• Creation of an internal market for CaR ( Exact

opposite of TD method . CaR allocated based on the

RAROC target a unit offers ).

• Negotiation ( Most common way to allocate ).

Comparison of Allocation methods

Parameter

Top-down Allocation

Negotiation

Internal Market

Expected Performance

High

Medium

NA

Promised Performance

NA

Medium

High

Historical Performance

Low

Medium

Low

Organizational Power

Medium

High

NA

Some Questions that arise !

• Similarity b/w allocation of CaR to business units to

the stocks scenario.

• Best estimate of expected returns – past, promised or

subjective expectation of top managers.

• Do divisional managers have more information ?

• Does the allocation take care of correlation effects ?

Right Measure of CaR

• Utilized CaR Vs. Allocated CaR

• Diversified Vs. Undiversified CaR

• In general , it is considered that actual amount of

utilized CaR is a better measure than CaR capacity.

• Cautious units are not punished for their behaviour.

• Units allocated CaR through a top down process are

not blamed for the disproportionate capital allocated

to them.

Right Measure of CaR.. Contd..

• it is not desirable to compare monthly profits to month-end daily CaR ( window dressing ).

• Units allocated CaR through a top down process are

not blamed for the disproportionate capital allocated

to them.

• Establishing profitability targets based on utilized CaR

can have the effect of eliminating each unit's

responsibility to exploit fully the resources that

have been assigned to it

Accounting for Diversification

Measure of CaR

• Residual Income = Earnings – CaR * kc • Using RI can lead to rejection of opportunities when

RAROC > Kc • If managers accept projects with return greater than

Kc but less than RAROC, they add value to shareholders but reduce the average RAROC

• Thus there is a moral hazard issue if manager’s incentives are based on RAROC.

• When the cost of capital is higher than current RAROC, adopting RI would lead the bank to refuse all investments that are expected to earn less than the cost of capital even if their adoption would improve current performance.

Inference

• Bank should not undertake a 5 yr loan if expected return is lower than cost of capital.

• In short term , marginal improvements to RAROC may be valuable , even if returns are less than Kc.

• Using RI or RAROC should be based on Whether the bank has shortage or excess capital Whether capital can be modified during the

average life of the business opportunity. • risk-adjusted performance measures on which incentive compensation should be based are not necessarily the same as those on which top managers should base capital-allocation decisions.

RAPM & Individual Performance Evaluation

• When does an RAP measure synthesize all the elements that must be considered to evaluate performance?

• One solution is to base it on whether the allocation is based on top down or internal market

• RAP can be good if transfer prices can be easily determined even in the short term and in a fair manner

• RAP measure is fine to evaluate market risk but not credit risk.

• Customer profitability can also be incorporated.

Thank You Srikanth Balasubramanian